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Bank of England risks falling behind the curve

Hefty recent interest rate rises by the US Federal Reserve and European Central Bank highlight the concern among central bankers that high inflation could become entrenched and spiral further beyond their control. With many advanced economies facing the spectre of recession, monetary policymakers are grappling with an unenviable choice: raise rates gradually, which will more slowly push up the cost of credit for already overburdened households, or front-load them to put an anchor down on soaring prices. The Bank of England will confront this trade-off when it announces its next interest rate decision on Thursday.

Since the BoE began lifting its pandemic-era stimulus in December with an initial 15 basis-point rise, it has raised rates in slow and steady quarter-point increments. The bulk of Monetary Policy Committee members have felt that fragile economic activity, amid a cost of living crisis, meant a half-point increase — its largest since 1995 — might be too aggressive. Yet with price pressures in the UK unlikely to ease off significantly in the near term, the BoE will fall further behind the curve on inflation if it fails to act more decisively.

Price pressures have strengthened since the bank’s previous meeting, when it warned it may need to act more “forcefully” if inflation looks more persistent. June’s annual consumer price index reading was 9.4 per cent, a new 40-year high. Food and petrol prices continued to soar, and factory-gate inflation pressures also mounted, with producer prices rising to a 45-year high. After the wholesale gas price surged again, the cap on household energy prices is projected to rise in October by a startling 70 per cent, and remain high into 2024. This means inflation could peak at even more than the 11 per cent-plus the BoE had already pencilled in.

At such heights the threat of “second-round” effects, where businesses push up prices and workers seek higher wages as household bills surge, becomes intense. Wages are not yet spiralling upwards uncontrollably. But at over 4 per cent, annual growth in regular pay is still above the roughly 3 per cent considered to be consistent with the bank’s 2 per cent inflation target — and unusually big bonuses and one-off payments mean total pay is growing even faster. Labour shortages will sustain wage pressures, while surveys show companies’ selling price expectations are still at elevated levels.

The bank can do little directly to ward off internationally-driven fuel, food, and supply chain cost pressures. Yet with business and household price expectations crucial to how high price dynamics become embedded, the bank will face a credibility problem if it is not seen to be acting robustly. While interest rates are a crude tool for quashing inflation, a more forceful 50 bps rise — which markets largely expect and BoE governor Andrew Bailey has said is “on the table” — would act as an important signal to damp inflation concerns.

Some may point to easing core inflation and surveys that show price expectations cooling as justification for less urgency, but upside risks to inflation remain. With other central banks shifting to larger rises, relatively lower UK interest rates could drive the pound weaker, raising imported inflation. The war in Ukraine means food and energy prices will remain volatile. And both Conservative leadership candidates are touting tax cuts that would add further fuel to the inflationary fire.

Waiting for even clearer evidence of persistent inflation would already be too late. The MPC has to decide what is the bigger risk: putting downward pressure on economic activity now, or allowing price dynamics to get out of control, which would entail potentially more painful and damaging rises later on.

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